In an effort to explain the annexation of Crimea, there has been a great deal of coverage surrounding the region’s ethnic ties with Russia and the political motivations of the move. After all, it was only 60 years ago that Crimea was gifted to Ukraine by Russia and it’s fairly understandable that Russia is a little antsy at the idea of having NATO on its doorstep in the wake of the ousting of President Viktor Yanukovych in the Ukrainian uprising. However, less attention has been paid to the underlying energy-related economic motivations of the move and therein lies a clearer picture of why Crimea is so important.
A couple weeks ago Russia’s state owned Gazprom announced that it would be tightening the screws on Ukraine by withdrawing the natural gas discount they provide in the second quarter of this year. In the wake of this, the Ukraine will likely face a price increase in the neighborhood of 30%. Ukraine enjoyed the discount on Russian gas as part of a prior agreement between Vladimir Putin and the former Ukrainian president, whereby the Ukraine rejected a pact with the E.U. in favor of closer ties with Moscow, a move that led to three months of mass protests, violence and an eventual regime change.
The Ukraine is the primary means by which Russian gas reaches Europe: 50% of Europe’s natural gas imports from Russia travel across the Ukraine. The country annually consumes approximately 50 billion cubic meters (bcm) of natural gas and produces roughly 22bcm, leaving about 28bcm to be covered by way of imports.Russia is the source for the lion’s share of those imports, at nearly 26bcm.1 As such, Moscow has enjoyed considerable influence over its neighbor since the breakup of the former Soviet Union, having gone so far as to shut off the gas to the Ukraine twice since 2006 in order to steer Ukrainian politics the way it wanted.
Russia’s annexation of Crimea was swift, unapologetic and left most the world astounded at how quickly it all transpired. There was no immediate threat and the area accounted for a meager 4% or less of Ukraine’s GDP.2 So why so fast? The answer appears to lay offshore of the Crimean coast.
The waters offshore of Crimea are said hold between 4 trillion and 13 trillion cubic meters of natural gas according to the Ukrainian government, and with development capex in the range of $8-9 billion could produce 9.7 billion cubic meters (bcm) of gas by 2030.3 However, any chance of getting out from under the thumb of Russia or realizing the future monetary value of those energy assets disappeared from Kiev’s balance sheet as soon as Crimea was annexed. From the Kremlin’s perspective, who exported nearly 6,248bcm in 2012 according to the EIA,4 this isn’t a huge play but it’s a decent addition to their reserve base and it keeps the Ukraine in their place: a customer in need.
In the weeks before the uprising and overthrow of the government, it was reported that ExxonMobil and Royal Dutch Shell, acting as leads of a consortium, were in production sharing negotiations with the government concerning the Skifska offshore gas field. Interestingly there was only one other bid for the development of the Skifska field and that came from Moscow-based oil and gas company Lukoil.5 In the wake of the hostilities, Exxon announced that negotiations would be put on hold.6 Given that Russian legislation stipulates that any offshore production in Russian waters requires 51% of state ownership, post annexation this consortium has a new “opportunity set” to consider. ExxonMobil and Shell may find that the new terms are not nearly as enticing as they once were. Not to worry though, Gazprom or Lukoil might be interested.
Over the years, Russia has reduced its reliance on the Ukraine as a transport corridor. In the past 80% of Europe’s natural gas imports from Russia traveled through the Ukraine, but that has fallen to 50% following the completion of the construction of the Nord Stream gas pipeline in 2012.7 Gazprom plans to continue the process of securing its gas shipments to its largest customer and bypassing countries it doesn’t want to deal with by building the South Stream Natural Gas Pipeline. The proposed route goes under the Black Sea to Bulgaria and then on to the rest of Europe. Prior to the annexing of Crimea, the proposed route took the South Stream Pipeline around Ukrainian waters.
This is where the plot thickens. A motivating factor behind the swift annexation of Crimea may lie project costs. Estimates are that Gazprom could save $10 billion in construction costs and greatly reduce the complexity of construction by moving into shallower waters.8 In looking at the Black Sea it becomes visually apparent that running a pipeline through the Crimean peninsula (the peninsula off of Ukraine the extends well into the Black Sea) and along the shelf would be a much simpler, dramatically cheaper and easier to maintain initiative than going through the middle of the Black Sea where depths can reach more than 7,000 feet.9
(Chart: http://en.wikipedia.org/wiki/File:Black_Sea_map.png) (Chart: http://geostrategy.org.ua/en)
In recognition of this, the E.U. is talking tough about South Stream while looking for ways to reduce its reliance on gas from Russia. As it progresses down this path it could look to countries like Iran who have significant offshore reserves. However, the fact remains, Russia has the ability to trump most foreign producers on a cost basis (no liquefaction or regasification process required and much of the infrastructure is already in place).
In summary, Russia is a resource-based economy. Oil and gas revenues account for more than 50% of the country’s federal budget revenues.10 Crimea’s annexation was to a large degree an opportunistic move for Russia that it knew it could get away with. In doing so, Moscow was able to add to its gas reserves, improve its naval position in the Black Sea and probably save some rubles as it improves its pipeline infrastructure to its number one customer.
A significant percentage of the world’s oil and gas reserves are located in regions that are becoming increasingly challenging (to say the least) to do business in. When one blends the uncertainty that energy geopolitics like this or those that can be found in resource rich regions of the Middle East, Africa or Latin America into a world that is becoming increasingly dependent on higher cost unconventional production, it becomes clear in the long run that the prices of oil and gas are seemingly destined to go higher. We believe that finding investments in long-lived production at or below the marginal cost of a barrel of production in countries with minimal geopolitical risk is key to securing returns in the long run.